by Guest Author John Hempton, Bronte Capital
China is a kleptocracy of a scale never seen before in human history. This post aims to explain how this wave of theft is financed, what makes it sustainable and what will make it fail. There are several China experts I have chatted with – and many of the ideas are not original. The synthesis however is mine. Some sources do not want to be quoted.
The macroeconomic effects of the Chinese kleptocracy and the massive fixed-currency crisis in Europe are the dominant macroeconomic drivers of the global economy. As I am trying a comprehensive explanation for much of the world’s economy in less that two thousand words I expect some kick-back.
China is a kleptocracy. Get used to it.
I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:
(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US;
(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud;
(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.
This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.
China has huge underlying economic growth from moving peasants into the modern economy
Every economy that has moved peasants to an export-orientated manufacturing economy has had rapid economic growth. Great Britain industrialized at about 1 percent per annum. It was slow because all the technology needed to be invented for the first time. During the 19th Century US economic growth – once started – ran about twice the rate of the UK. They copied the technology which was faster than inventing it. Later economies (eg Japan, Malaysia, Thailand, Korea) went later and faster. As a general rule the later you industrialized the faster you went – as the ease of copying went up. In the globalized internet age copying foreign manufacturing techniques and seeking global markets is easier than ever – so China is growing faster than any prior economy.
This fast economic growth – which would happen in a more open economy – is creating the fuel for the Chinese kleptocracy.
The one-child policy drives massive savings rates
The other key fuel for kleptocracy is a copious supply of domestic savings to loot. The reason Chinese savings levels are so high is the one-child policy.
In most developing countries the way that people save is they have multiple children hopefully to generate a gaggle of grandchildren all of whom are trained to respect their elders. Given most people did not live to old age if you did you became a treasured (and well cared for) family member.
This does not work in China. Longevity in China is increasing rapidly and the one-child policy results in a grandchild potentially having four grandparents to look after. The “four grandparent policy” means the elderly cannot expect to be looked after in old age. Four grandparents, one grand-kid makes abandoning the old-folk looks easy and near certain.
Nor can the elderly rely on a welfare state to look after them. There is no welfare state.
So the Chinese save. Unless they save they will starve in old age. This has driven savings levels sometimes north of fifty percent of GDP. Asian savings rates have been high through all the key industrializations (Japan, Korea, Singapore etc). However Chinese savings rates are over double other Asian savings rates – this is the highest savings rate in history and the main cause is the one-child policy.
Low and middle income Chinese have very limited savings options
The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can’t invest in any foreign assets.
Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.
What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.
Bank deposits and life insurance as a savings mechanism in China
Bank deposits rates are regulated. You can’t get much different from 1 percent in a bank deposit. Life insurance contracts (a huge savings mechanism) are just rebadged bank deposits – attractive because the regulated rate is slightly higher.
This is a lousy savings mechanism because inflation has been between 6 and 8 percent (but is now lower than that and is falling fast). At almost all times (except during the height of the GFC) the inflation rate has been higher – often substantially higher – than the regulated bank deposit (or life insurance contract) rate.
In other words real returns for bank accounts are consistently negative – sometimes sharply negative.
You might ask why people save with sharply negative returns. But then you are not facing starvation in your old age because of the “four grandparent policy”. Moreover because of the underlying economic growth (moving peasants into a manufacturing economy) there are increasing quantities of these savings every year. This is the critical point – the negative return to copious and increasing Chinese bank deposits drives a surprising amount of the global economy and makes sense of many things inside and outside China.
The Chinese property market as a savings mechanism
Chinese people have very few savings mechanisms. The major ones (bank deposits and their life-insurance contract twins) have sharp and consistently negative real returns.
Beyond that they have property.
Bank deposits have sometimes 5 percent negative returns. If you got 1 percent negative returns from property – well – you would be doing well. Buying an empty apartment and leaving it empty will do fine provided you can sell the property at some stage in the future.
It is commonplace amongst Western investors to view the see-through apartment buildings of China as insane. And they may be a poor use of capital. But from the perspective of the investors – well they look better than bank deposits.
Negative returns on bank deposits and the Chinese kleptocracy
Most Chinese savings however are not invested in see-through apartment buildings. Bank deposits still dominate. The Chinese banks are the finest deposit franchises in human history. They can borrow huge amounts at ex-ante negative real returns.
And those deposits are mostly lent to State Owned enterprises.
The SOEs are the center of the Chinese kleptocracy. If you manage your way up the Communist Party of China and you play your politics really well may wind up senior in some State Owned Enterprise. This is your opportunity to loot on a scale unprecedented in human history.
Us Westerners see the skimming arrangements. If you want to sell kit (say high-end railway control equipment) to the Chinese SOE you don’t sell it to them. You sell it to an intermediate company who on-sell it in China. From the Western perspective you pay a few percent for access. From the Chinese perspective – this is just a gentle form of looting.
And it is not the only one. The SOEs are looted every way until Tuesday. The Business Insider article on the spending at Harbin Pharmaceutical is just a start. The palace pictured in Business Insider would make Louis XIV of France (the Sun King) proud. This palace shows the scale (and maybe the lack of taste) of the Chinese kleptocracy.
A normal business – especially a State Owned dinosaur run by bureaucrats – would collapse under this scale of looting. But here is the key: the Chinese SOEs are financed at negative real rates.
A business – even a badly run business – can stand a lot of looting if it is (a) large and (b) funded at negative real rates.
Those negative real rates are only possibly because there are copious bank deposits available at negative real rates to State controlled banks.
The cost of funds in China and the willingness to hold foreign bonds
The Chinese Government (and the banks are part of the government even though they are listed) has access to seemingly unlimited bank deposits at negative real costs.
When you have copious funds at a negative cost a lot of investments that look stupid under some circumstances suddenly look sensible. US Treasuries look just fine. Don’t think the Chinese are going to stop holding Treasuries. The Treasuries yield far more than they pay the peasants. The Chinese make a positive arbitrage on holding low rate US bonds.
Monetary threats to the Chinese establishment
The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese.
There are two core threats to this system – one widely discussed – one undiscussed.
Inflation (widely discussed) is known to produce riots and demonstrations in China – and is considered by Westerners to be bad news for the Chinese establishment. And there are good reasons why the Chinese riot with inflation – the poor who save because they are going to starve – get their savings taken away from them.
But ultimately the Chinese establishment likes inflation – it is what enables their thievery to be financed.
The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate – well that is a completely different story.
The real threat to the Chinese establishment is that the inflation rate is falling – getting very near to the 1-3 percent range.
Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.
But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them – and paying them is inconsistent with looting.
If the SOEs cannot pay then the banks are in deep trouble too.
The trouble is arriving because the inflation rate is dropping. Maybe they can stop it dropping. The Chinese establishment has a vested interest in getting the inflation rate up in China, because if they don’t all hell will break loose.
Unless the Chinese can get the inflation rate up expect a revolution.
A follow-up discussion of the article is posted at Bronte Capital.
About the Author
John Hempton has an extensive background in the international finance industry. Amoung his many prior positions include Chief Analyst at the New Zealand Treasury and Executive Assistant to the CEO at ANZ Bank New Zealand are his most recent. Before obtaining his current title of CEO at Bronte Capital, John was a financials analyst and junior partner at Platinum Asset Management. While there, he was accountable for managing international financial stocks. John is currently the Chief Investment Officer at Bronte Capital.